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WF : The wait for inflation to come under control and for interest rates to start declining has been a long one. Is our wait finally over? How do you see inflation and interest rates moving for the rest of this fiscal year and into the next one?
Akhil: The way RBI looks at inflation and formulates its Monetary Policy towards that, has seen a dramatic shift in last 1 year since change of guard at RBI. The two changes are: Shift from WPI to CPI as inflation benchmark and targeting inflation systematically to bring it down sustainably. These two changes meant that RBI had to adopt hard organic measures to tame inflation and continue to tread the disinflationary path (repo rate above CPI) as long as upside risks to inflation remain.
As of now, we feel that the near term glide path target for inflation (8% for Jan 2015) is achievable, but there are still upside risks to Jan 2016 target i.e rise in food inflation on account of deficient monsoons, crude price risk owing to geo-political issues, and possibility of growth led price increase. We believe that these risks (whether they will materialize or not) will unfold over next 3 to 6 months and hence RBI will want to wait for such time before starting an easing cycle. Hence we believe that monetary policy easing cycle would start by next fiscal year.
As far as remainder of fiscal year goes, we believe that interest rates will remain range bound as we do not see rate cuts starting this fiscal. Towards the fag end of the fiscal though, if the government is able to achieve fiscal consolidation above its target and provide a more promising deficit target for FY16, RBI might consider easing policy. We, thus, believe that easing cycle will start next fiscal. Also, what is probably going to be different in next monetary policy cycle is that we will not get front loaded rate cuts as in previous easing cycles. This time, it would be small calibrated steps so that there are no substantial upside risks to inflation. RBI wants to provide with a clear and predictable policy which has a longer cycle so that medium term economic targets are met.
Our expectations for CPI inflation numbers are 7.50% - 8% for March 2015, 6% for March 2016, and 5% - 5.5% for March 2017. Accordingly, we see rate cuts to extent of 50-75 bps in FY 2015-2016 and similar move in FY 2016-2017. Hence our 10yr Gsec targets are 7.50% - 7.75% for March 2016 and 7.00% by March 2017.
WF : With oil prices dropping, there seems to be a lot of relief on the fiscal deficit situation. How do you see the fiscal deficit situation panning out this year and the next and what implications might this have on Government borrowings and interest rates?
Akhil : Fiscal Deficit was one of the key drags on Interest rate market for past few years. The current government has laid down fiscal consolidation roadmap and has set fiscal deficit target of 4.10%, 3.60% and 3.00% for FY 2015, 2016 and 2017 respectively. Subsidy burden has been one of key social expenditure of the government and has drawn lots of criticism from markets. Within overall subsidies, fuel subsidy has been substantial proportion and government has time and again asserted that they would reduce it. With international crude prices falling, there has been a tremendous relief for the government as both petrol and diesel under recovery have been completely wiped out as on date. This would also have favourable impact on LPG subsidy. Overall, this reduces the subsidy burden of the government.
Though the reduction in subsidy burden improves the fiscal situation, it still might not result in lower fiscal deficit in current year. The budget had assumed aggressive targets on indirect tax collections and also disinvestments, which might be difficult to achieve. So any shortfall in these would be off-set by reduction in subsidies. Hence, we believe this year fiscal deficit will be same as budgeted. Going ahead in next financial year, we would expect government to further consolidate the fiscal and reduce subsidies. Low crude prices will definitely be a big help there.
On the qualitative side, lower crude prices will have favourable impact on Current Account deficit. Also, it reduces the suppressed inflation in the system, which has been an area of concern for RBI. Overall, falling crude prices are favourable for our economy and definitely help fiscal side and inflation. This is a positive for interest rate markets should lead to lowering of rates, other things remaining same.
WF : Some experts are drawing parallels to the 2001-2004 scenario, where we saw a steep decline in interest rates, leading to handsome gains from bond funds over those 3 years. Are we at the beginning of a similar phase? How do you see the next 3 years for bond and gilt funds?
Akhil: India has been facing problems of Twin deficits (Fiscal Deficit and Current Account Deficit), High Inflation, Volatile Currency and Policy paralysis, which led to host of problems in interest rate markets. As discussed above, we see problem of twin deficits getting resolved / or on path of coming in acceptable zone. Also, inflation has been falling and dis-inflationary process of RBI will ensure that inflation comes down sustainably. A clear mandate and stable government with complete majority has for now given an impression of removal of policy / procedural bottlenecks and concentrating on reviving growth.
All these factors provide a good outlook on economy over next 2-3 years, hence we are bullish on economy and interest rates with a 2-3 year view. We believe interest rates should fall as RBI moves to ease monetary policy and hence bond funds / gilt funds are likely to gain from such a move. We also believe that G-sec would be best positioned for next economic move as high supply of G-sec papers in past 3-4 years have led to sharp uptick in G-Sec yields. Going ahead, with fiscal consolidation and limited supply of G-Sec papers, it should perform well. Hence within interest rate space, we believe g-sec funds should perform well in next economic cycle.
WF : What is the positioning of your Medium Term Gilt Fund and how is it different from gilt funds that we normally find in the industry?
Akhil: Tata Gilt Mid Term is a medium term government securities Fund with a focus on capital appreciation opportunities. The Scheme aims to invest in the medium to longer end of the yield curve with a relatively passive portfolio management strategy. The Fund currently sees opportunities to generate accrual and capital appreciation opportunities in medium term G-sec papers along with SDLs. The portfolio is positioned for capturing the next economic / interest rate cycle.
WF : How is the portfolio of your Medium Term Gilt Fund structured to capture your interest rate views?
Akhil: With a view to capture interest rate cycle as envisaged over next 2-3 years, Tata Gilt Mid Term Fund aims to generate regular accruals and capture capital appreciation opportunities. The portfolio aims to invest in government securities with capital appreciation opportunities in medium end (8yr to 13yr segment) of the yield curve and small proportion in state development loans to maintain accruals. Such investment strategy would ensure that portfolio is invested at higher yield levels as compared to current belly of the curve and 3 years down the line, the portfolio would be at belly. Hence, as per our view, entry premium risk and exit premium risk would be minimal.
The portfolio is relatively passively managed as it endeavors to capture a longer cycle and hence relatively insulated from intervention based on smaller cycle views, which are at risk to go wrong. Hence this is different proposition from actively managed gilt funds.
WF : What are the key risks to the bond market at this juncture?
Akhil: To mention in brief, there are 2 major risks that bond markets are facing:
Currency risks: strengthening dollar is a cause of concern as it might lead to EM sell-off in a risk-off trade and hence INR might see big outflows. Geo-political risks: Crude oil can be a party spoiler in case geo political crisis deepens, as India's finances are highly dependent on crude.
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